Inflation, the old enemy, is back. But this is no time to be frightened

Tuesday will bring more gloomy economic news in the wake of rising petrol, energy and food prices. The Bank of England will be under pressure to act to curb inflation; but some believe inaction will be the most courageous choice of all

The power of inflation: Margaret Thatcher makes her famous demonstration of the erosion of purchasing power in 1979. Photograph: Trinity Mirror/Mirrorpix/Alamy

The City is braced for bad news when the latest set of inflation figures are released on Tuesday, with petrol, energy and food prices all going up. The "Primark effect", which allowed high-street clothing retailers to offer low-price fashion goods, has gone into reverse: a weak pound and sky-high global commodity prices are pushing up the cost of living and creating a headache for the government.

At the Bank of England, the monetary policy committee is also prepared for the worst. The nine MPC members had an early squint at the December number for the consumer price index (CPI) before they left interest rates on hold last week, but Threadneedle Street's own forecasts show inflation continuing to climb over the next few months from its current rate of 3.3%.

So far in January, the inflation news has been relentlessly poor. Rail fares have gone up by well in excess of inflation; VAT has gone from 17.5% to 20%; a fresh surge in oil prices to just under $100 a barrel threatens fresh misery for motorists already having to adjust to the idea that it now costs £50 or more to fill up the family car.

It's all relative, of course. On the measure favoured by the government – CPI – inflation is currently 3.3% and is likely to hit 4% within the next few months. In the 1970s, when Margaret Thatcher was famously pictured holding bags of shopping to show how consumer spending power had been eroded under the Labour government, inflation hit a post-war record of 26%. In the early 1980s, the Iron Lady herself had to grapple with inflation again above 20% while a third spike in prices to just under 10% as a result of the ill-fated Lawson boom was a factor in Thatcher's defenestration by her party in 1990.

But the trend is upwards and there is a sense that, rather like alcoholism, the problem never entirely goes away. The last time inflation was below the government's 2% target was November 2009. Since then it has been 3% or higher in all bar one month and Bank of England governor Mervyn King has had to write a series of letters to George Osborne explaining the Bank's failure to meet its official remit. A year ago, it expected inflation to be coming down in early 2011. It is sticking by its line that the UK is suffering from a temporary inflation shock, but says the improvement will not be seen for a further 12 months. Like the Bank, the City has been regularly caught on the hop by the strength of the inflation data, and for some the Bank's explanations have started to wear a bit thin.

"The Bank has been wrong on inflation for far too long. It needs to grasp the nettle, and sooner rather than later," says Michael Derks at foreign-exchange broker FxPro Financial Services.

Derks means the MPC should start to edge up interest rates from the emergency level of 0.5%, where they have been for almost two years: "The committee may find it very difficult not to raise rates in coming months because a failure to do so would risk an even greater loss of credibility than it has suffered thus far.

"Also, the current stance of monetary policy is incredibly stimulatory, with base rates of just 0.5% and inflation above 3%. Real after-tax interest rates are substantially negative. As such, raising the base rate from 0.5% to, say, 1% over coming months would still render the stance of policy very accommodating, and would be very unlikely to derail the economy, notwithstanding the growth headwind from fiscal austerity."

This line of argument is echoed inside the Bank, but thus far only by one of the nine MPC members, Andrew Sentance, who has stressed the economy's "bouncebackability" following the deep recession of 2008-09. He has argued that growth in both the second and third quarters was unexpectedly strong and it is time the Bank started to withdraw some of the stimulus provided by loose monetary policy.

Thus far, Sentance has been unable to convince the other members of the MPC, but the minutes of the December meeting suggested growing concern about inflation. There have been signs that consumer expectations of the future path of inflation have risen; were this to be accompanied by evidence that wage bargainers were securing higher pay deals to compensate for rising prices, the Bank would raise rates.

Some analysts believe this would be a big mistake, akin to the Bank's failure to cut rates in the summer of 2008, when, although record oil prices of almost $150 a barrel pushed inflation up, the real threat to stability was from a tottering global financial system and recession. "The MPC may be bludgeoned into a rate hike by a growing army of critics," says Graham Turner of GFC Economics. "In truth, the asymmetric risks of getting policy wrong today are too great to justify such a move."

The policy dilemma is a far cry from the years immediately after the Bank was granted independence to set interest rates by Gordon Brown in 1997. For the first 10 years of its life, the MPC kept inflation within one percentage point of its target and neither King nor his predecessor as governor, Eddie George, was obliged to write an explanatory letter to the chancellor. At that time, all the cards were stacked in the Bank's favour: the opening-up of China and India as market economies provided a new source of low-cost goods; the strength of the pound made imports cheaper (while making life tough for exporters) and oil prices rarely rose above $25 a barrel. Computers, mobile phones, TVs and women's clothes all became much cheaper.

Most of these factors have gone into reverse. The cost of audio-visual equipment is still dropping, but rapid growth in some big emerging economies has had an impact on labour costs and the price of raw materials. Simon Wolfson, chief executive of clothing chain Next, has warned that the rising cost of cotton, compounded by higher VAT, could push the price of clothes up sharply this year. Oil prices started to rise shortly before the Gulf war of 2003 and fell back only briefly during the slump of 2008-09.

For consumers, many coming to terms with pay freezes or modest wage increases, rising inflation means low real incomes. If prices are going up by almost 5% a year (as they are according to RPI – the retail prices index – used as the benchmark for most pay deals) and earnings are going up by 2%, the choice is to accept a drop in purchasing power of three percentage points or borrow more to bridge the gap.

The last Labour government was most popular in its first term, when real incomes were rising strongly, and least popular in its third term, when real incomes barely grew at all. As things stand, 2011 will see a hefty drop in disposable incomes – a trend not lost on David Cameron, who used an appearance on the Andrew Marr show a week ago to express concern about prices.

The question is what to do about it. Geoffrey Dicks at Novus Capital Markets admits that the inflation numbers are going to be "ugly" over coming months, but puts this down mainly to VAT and other tax increases.

Inflation measures that exclude the effect of tax rises are running comfortably below 2%, he says. "To have kept inflation to 2% in the face of higher taxes would have required getting 'CPIY' inflation [a version of CPI which omits the effects of indirect taxation] down to the 0-0.5% range. That would have required a considerably tighter policy stance, which might have prevented the 2010 recovery in activity."

That, then, is the MPC's dilemma: bow to its growing army of critics and risk pushing the economy back into recession, or tough it out and risk a loss of credibility if inflation continues to rise. It is not an enviable choice.

"Rate hikes would kill core inflation, but they would also be GDP suicide in this fragile economy, bringing deflation risks back into play," says Jim Leaviss at fund manager M&G. "Hopefully, the Bank still feels it can target future inflation and has the confidence to ignore those reacting to the current inflation news flow.

"But I don't think that the Bank of England has much breathing room left, and with persistently high current inflation the Bank's credibility is under attack. I think we're only one surprisingly robust inflation point away from a UK rate hike. Let the policy errors begin…"